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State Hybrid Pension Plans Continue to Gain Popularity

The increasing indebtedness of state pension systems means that state budgets are facing significant pressure and tough financial decisions, according to a recent Wall Street Journal article titled, “New Jersey Needs a Pension Fix. Is This It?”

According to data from the Pew Center, the funding level of New Jersey’s pension system ranked #50 in the nation as of 2016. New Jersey’s state pension plans had only $75 billion in assets that year, despite having a total pension liability of $244 billion. The pension shortfall of $168 billion as of 2016 means that funding pressure on other essential state programs is increasing. At the same time, the pension deficit continues to grow by billions of dollars annually.

The New Jersey Senate President recently explained that the state’s “pension system is in a crisis.” The New Jersey pension program is one of the most indebted retirement systems in the entire country. In fact, estimates project that New Jersey pension payment obligations will more than double by 2023. “It’s crowding out any investment we want to make,” says the Senate president.

According to a recent report by Moody’s Investors Service, New Jersey would only be able to pay four years of benefits for the state’s teacher pension fund in the event of another financial crisis. Currently, the state’s teacher pension is only funded at a level of 26 percent, while the state’s public worker pension plan is funded at a level of only 40 percent.

If nothing changes, New Jersey will pay out an estimated $6 billion or more in annual pension payments by fiscal year 2023, nearly doubling the amount paid in the fiscal year that ends June 2019. This increase is expected to total over 80 percent of the state’s revenue growth.

To ease the situation, New Jersey state lawmakers are proposing an overhaul to the state’s pension system by moving state workers and teachers with less than five years of experience, as well as future new hires, to a hybrid retirement plan. This new plan would blend pensions with something similar to a 401(k) plan, though it poses some investment risks.

The pending legislation would guarantee benefits for New Jersey workers with a pension on the first $40,000 they earn. Any income over that threshold would be covered by an annuity or 401(k)-like plan. Police, firefighters and judges would not be affected by any changes. Other suggestions include raising the retirement age to 67 from 65 and other actuarial adjustments.

According to the New Jersey Senate, this proposal would save the state nearly $25 billion over the next three decades while reducing the state’s unfunded liability by nearly $18 billion over the same period. Legislators believe that attempts to limit the impact on workers is a better option than proposing draconian cuts to the program. The pension proposals are creating controversy within the state, and there is talk about the possible need for a constitutional amendment in order to gain passage.

Nationally, Many States Adopt Hybrid Pension Plans

Sharing investment risks with public workers is a political maneuver gaining support across the country. According to the National Association of State Retirement Administrators, more than 10 major public plans attached at least a portion of their public workers’ retirement benefits to market performance since 2008.

Other states that have also recently moved new public workers to risk-sharing pension plans, including Arizona, Connecticut, Kentucky, Rhode Island, Tennessee, and Utah.

In 2011, all state workers in Rhode Island with less than 20 years of service were moved to a hybrid risk-sharing plan. Other states have chosen a more conservative approach of focusing benefit changes on new or more recently hired workers, since these workers are less likely to be protected by the courts. For example, new public school employees in Pennsylvania will join a risk-sharing pension plan starting in June 2019.

After Rhode Island increased the retirement age and reduced cost-of-living increases for plan participants, the funding level of the Rhode Island hybrid plan increased to 54% from 48% and its market value rose by about $1 billion. This means that the plan remains severely underfunded, even though risk levels have declined.

Background on Pension Reforms and State Pension Funding Levels

In the past, public workers were generally promised a specific dollar amount of pension benefits in relation to their salary, tenure status, and other relevant factors. This type of plan is referred to as a “defined benefit” plan. The plan sponsor tended to fill in the gaps whenever pension investments were insufficient to cover the costs. However, state governments began to consider different approaches after pension funds were adversely affected by the financial crisis of 2007-2008. A 401(k)-type plan is referred to as a “defined contribution” plan, in that the future benefits are determined by the amount of money the plan participant contributed to the plan over time.

The health of a pension plan is often determined by its “funded ratio,” which is defined as the level of assets in proportion to accrued pension liability. The funded ratio is an annual “point-in-time” measure as of the valuation date.

The Pew Charitable Trusts reported in a 2018 report titled “State Retirement Fiscal Health and Funding Discipline” that the average funded ratio for state pension plans across the country was 66 percent in 2016. Total pension investments of $2.8 trillion have been set aside against $4.0 trillion in promised benefits, resulting in a shortfall of more than $1 trillion. A funded ratio of 80 percent is often viewed as the point at which a pension plan is financially sound.

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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